When I was 25, I was already dreaming about financial independence. On one side, my father was enjoying his job even when close to retirement, while I was considering it (retirement) at the outset itself. Read more about how to be financially independent.
I wanted to retire for the sake of financial independence. My father was planning retirement as it was inevitable due to his age. Both of us had a different perspective about retirement.
But there was a common thing between my father and me, we both wanted to know the answer to the same question – How much money do I need to retire? The answer hides in our ‘retirement corpus’. Read more about NPS for retirement corpus building.
The bigger is the retirement corpus, more income it will yield. So the question arises, how big should be the retirement corpus? This is what we will try to answer in this article.
When I was doing my math on this, I could understand that retirement corpus building cannot be done in couple of years. Why? Because the amount that has to be accumulated is huge.
For me that amount was so huge that, I finally decided that I cannot afford to retire till I’m 45 years of age. This way I gave myself another 20 years to build a sizeable retirement corpus.
The Concept of Retirement Corpus
To support the lifestyle after retirement, one must ensure that sufficient retirement income must be yielding (step #4). Retirement income will come from the retirement corpus (step #3).
The challenge is to build a big-enough retirement fund. How to do it? Earn more, spend less, save high, and use the saving to build retirement fund. Following are the 4 steps worth remembering:
- Generate Income: How one can generate income? By doing a job or business. The idea of income generation should be to empower oneself to build a big-enough retirement corpus.
- Save Money: Generating income is only the first step. In order to build a sizeable retirement corpus, one must also save sufficient money. Why? Because this saving will ultimately build the retirement fund. Read more about tricks to save money.
- Retirement Corpus: The money saved from ones income must be invested well, to build retirement corpus fast enough. But the size will grow at rather slow pace – specially in initial days. One must not get disheartened, and shall continue to contribute to this cause year after year. Read more compounding investment returns.
- Retirement Income: Building a big retirement corpus is an important milestone. But this is not the end. Taking one more step is essential. What is the next step? Reinvesting ones retirement fund so that it starts generating regular income (post retirement). Read more about where to invest retirement fund for income generation.
Once this clarity is established, we are ready to ask the next questions. “How much money will be enough to retire? What should be the size of my retirement corpus?
How to estimate size of retirement corpus?
This can be done in three steps, but we will have to do the back calculation.
- Monthly Expense: This is the first step. Try to estimate what will be the expense you would like to carry after you have retired. You must also consider additional expenses like medical, travel etc which might increase post retirement.
- Expected Returns: When we are in job, we can take more risks. Hence we can afford to invest in high-risk-high-return investment options. But post retirement, our risk taking capability falls drastically. Hence our expected return from investment should be accordingly tuned. I will not expect more than 7% return from my retirement portfolio. Read more about how to measure investment returns.
- Size of Corpus: This is the final step. It will tell you what will be your required retirement corpus. How to do it? Use this formula: Corpus size = (Monthly Expense x 12) *100 / 7. The logic is that, the retirement fund should be big enough to generate enough ‘interest income’ to take care of all daily expenses of life.
Suppose ones monthly expense is say Rs.10,000. The person decides to invest his retirement savings in a monthly income plan which yields a return of 7% p.a. What should be the size of retirement corpus (which generates Rs.10,000 per month)? Size of corpus = (10,000 x 12) *100 / 7 = Rs.17.15 Lakhs.
1. Estimate Monthly Expense
Suppose you are 59 years of age. In next few months, you are going to retire from your job. What will be your expenses after retirement?
One must be careful while answering this question. Why? Because here, one must neither overestimate nor underestimate the requirement.
So how to approach this question? Create a break-up of your total expenses into following six (6) heads, and quantify each one of them as shown below. I have also added some values for exemplification.
- Home Management: Utility bills, foods, maintenance etc: Rs.4.5 Lakhs per annum.
- Vacation: Money required for managing annual vacations: Rs.0.5 Lakhs per annum.
- Health Care: In old age the cost of managing health is high: Rs.1.0 Lakhs per annum.
- Income Tax Payment: Money to be paid to the government as income tax: Rs.1.5 Lakhs.
- Emergency: Money required to handle emergencies: Rs.1.5 Lakhs.
- Inflation Adjustment: Money that must be added back to the retirement fund to negate the effect of inflation: Rs.1.5 Lakhs.
Total annual expense after retirement (sum of #1 to #6) is Rs.10.5 Lakhs per year. What is this number, Rs.10.5 Lakhs?
It is the income that our retirement corpus must generate each year, post retirement. In other words, the size of retirement corpus must be big enough to generate a minimum income of Rs.10.5 lakhs per annum.
2. Estimate Size of Corpus
What we know now is that, our annual expense requirement post retirement will be Rs.10.5 Lakhs per annum. To meet this expense requirement, our retirement income must be at least Rs.10.5 lakhs per year.
This income will come from the retirement corpus. The retirement corpus must be big enough to generate Rs.10.5 lakhs per year of regular income.
How to know the size of Retirement corpus? Use this formula:
I have done the calculation. To generate an annual income of Rs.10.5 lakhs per year, @7% per annum, the size of the invested funds must be Rs.1.5 Crore.
3.1 Adjust for inflation…
What we need to adjust for inflation? The calculated retirement corpus (Rs.1.5 Crore).
Why we need to adjust it for inflation? Because Rs.1.5 Crore is the required-value if one retires tomorrow. If the person is going to retire after 20 years, the required corpus will be much higher.
What will be the value of Rs.1.5 Crore after 20 years? How much it will increase? We can use this formula:
Corpus(n) = Corpus(t) * (1 + 6%) ^n
- Corpus(n) = Corpus after 20 years.
- Corpus(t) = Corpus required today (1.5 Cr).
- n = 20 years.
- 6% = Average inflation in next 20 years.
Corpus(n) = 1.5 * (1+6%) ^(20) = 1.5 * 3.21
Corpus(n) = Rs.4.85 Cr.
So what this calculation land us into? More trouble? Yes.
Rs.1.5 Crore as retirement corpus anyways was a huge amount. But now what we have in our hand is even bigger value (Rs.5.0 Crore). But to build it, we have 20 years time in our hand.
My personal estimate is that, investing Rs.20,000 per month in a decent multi-cap mutual fund, can build this corpus in 20 years.
- Read more about potential mutual fund returns here.
- You can also use my SIP calculator to estimate the monthly investment necessary to build the retirement corpus.
We wanted to know how much money do I need to retire at 45? To get an answer, we started with expense calculation (Rs.10.5 Lakhs / year – example).
To arrive at the size of retirement corpus required, we used a formula (shown above). The calculated value of the required retirement corpus was Rs.1.55 Crore.
But this value of Rs.1.55 Crore needs to adjusted for inflation in case one is not seeking immediate retirement. We have seen, how one can adjust the retirement corpus for inflation.
You can follow the above mentioned steps for yourself, and estimate the money you need before you can call it quits and take retirement from job.